A year ago, alternative lenders in B.C. were optimistic that 2010 would be a turnaround year following a disappointing 2009. For many, however, it took longer than expected as the clouds of economic uncertainty persisted in the first half of the year.
Axel Christensen, B.C. managing director of BDC Subordinate Financing said, “The start of the year was very slow. There was still a lot of uncertainty since we were in the middle of the worry of a double-dip [recession].”
While many said there was a year-over-year increase in financing last year compared with 2009, the market remained muted for Vancouver’s mezzanine lenders that provide financing above what can be provided by senior lenders like the chartered banks.
Derek Strong, district manager at Roynat Capital, said, “2010 was a recovery from one of the worst years for many, which was 2009. I wouldn’t say it was a great year, it was an average year.”
Davis Vaitkunas, president of Bond Capital, noted while activity last year was below average, his firm was active around a number of going-private transactions as well as equipment financing.
“Clearly, any management team that took their company private did quite well since the stock market was much lower than it is today.”
According to data from the Canadian Federation of Independent Business (CFIB), business confidence in B.C. resembled a rollercoaster in 2010. It fell consistently in the first quarter before rising to a yearly high in the second quarter. But it then plummeted over the summer to an annual low before recovering to confidence levels resembling those at the beginning of the year.
That level of uncertainty made it difficult for many business owners to commit to any growth plans. Robert Napoli, vice-president of First West Capital, a new subordinate financing firm that formed last October, said there was relatively little demand for growth capital from mezzanine lenders.
Financially strong companies that were looking to expand through the acquisition of competitors were also limited by the dearth of businesses up for sale in B.C. Napoli said companies were either waiting for their earnings to improve before going on the market, or were waiting on the sidelines of the M&A market, hoping for business valuations to further improve from the declines in 2009.
But the market for mezzanine debt had started to improve in the fourth quarter of 2010, with interest and activity ramping up for most subordinated finance providers. First West Capital, a subsidiary of First West Credit Union, launched with its $60 million fund in October. Napoli said since their launch, they’ve seen significant activity closing their first deal before Christmas and a second shortly after the new year.
“We’re seeing a mix of things,” said Napoli. “Some are looking for growth capital, quite a few technology companies that are growing quickly, but can’t quite get senior debt, and then some M&A transactions.”
The M&A space is generally a sweet spot for the mezzanine debt market, with mezzanine financing generally used to bridge the gap in a deal between senior debt from a bank and cash, or equity, from buyers of a business. Mezzanine debt is more expensive than senior debt, with pricing ranging from 15% to 25% depending on the lender, its fees, the structure and complexity of the deal, company’s cash flow situation and risk assessment.
The higher cost relative to senior financing from the chartered banks is due to the risk mezzanine lenders face since they generally provide financing based on a company’s cash flow instead of available collateral. It’s considered a niche area in corporate financing, often used to finance the goodwill portion of a sale.
Vaitkunas noted that the mezzanine market has been slow, partially because “there are fewer borrowers. Companies still have a lot of cash on their balance sheets. But some of them are starting to make their move and there are assets out there on sale.”
With more deal activity, competition between lenders is likely to grow. Most mezzanine lenders have noticed the banks offering more financing to close a deal. That’s been complemented by a growing number of auction-type transactions where multiple buyers look to acquire a single company. Napoli noted one deal that attracted both strategic buyers looking to expand their market share and financial players, like private equity funds, looking to deploy their capital.
“That’s an indication to me that things are starting to swing back toward a balanced market,” said Napoli. “But I think in 12 months it will become a seller’s market very quickly. We’re seeing some of the banks are getting pretty aggressive surprisingly quickly, offering acquisition financing and looking for deals.”
Lee Grimshaw, BMO Capital’s western Canadian managing director, noted that private equity firms and other foreign financiers are also starting to return to the Canadian market, further boosting the level of competition in the mezzanine debt sector.
“Last year was a big year for us, but there were more owner-operator, strategic transactions than private equity deals. That will change this year.”
That level of competition, however, should be good for business owners looking to sell. Strong noted, “When capital markets failed in 2008, basically, businesses couldn’t sell because they couldn’t raise debt. I think the significant change for 2011 for most companies will be that the availability of credit has dramatically improved, and at the end of the day, it’s going to push [earnings] multiples and valuation multiples up.”
Every mezzanine lender sees the improving economy facilitating the wave of M&A transactions expected as business owners more seriously begin their transition from the owner-operator of a business to retiree.
Strong noted, “What’s unique about 2011 is that it’s the first year baby boomers will start to retire; people have been putting it off for one reason or another; in 2008, 2009, it was because of the economy, but for a lot of people, age has caught up with them and they’ve got no choice but to move on and sell their business.”
“That’s not going to change over the next 10 to 15 years,” said Christensen. “That’s the primary driver for the mezzanine market. We’ve had the best nine months we’ve ever had in five years and we’re forecasting a good year for 2011.”
With two-thirds of small and medium-sized businesses estimated to be coming up for sale over the next decade, the amount of deal activity should keep lenders and private equity players increasingly busy.
But, Napoli noted, “At some point, there’s going to be a lot of businesses for sale, to the point that the demand-and-supply equation might be tipped against you. For those that haven’t prepared well for a sale, they might get passed along, or not get a good valuation.”
As the general economy improves, many mezzanine lenders noted the sector will likely face some short-term competitive challenges from other sources of capital. Asset-based lenders, for example, have seen significant growth in the past year.
John Freeman, the Vancouver-based senior vice-president at JP Morgan Chase, said, “The trends are all positive. 2009 was an absolute disaster; there was nothing done throughout the industry. 2010 was, hands down by far, our best year in Western Canada. Hopefully that continues in 2011.”
Asset-based lenders generally provide capital based on an unleveraged, or under-leveraged asset, such as machinery and equipment, receivables or inventory. The players in the sector include foreign lenders, the chartered banks and a niche pool of private lenders.
Since their capital is based on the value of collateral being offered by the company, asset-based lenders face higher costs associated with regularly assessing the value of the underlying asset. Those costs are passed on to the borrower as part of the cost for a line of credit or a short-term loan with terms ranging from a few months to a few years.
The market has generally been challenging for traditional asset-based lenders, because they generally thrive when companies are growing and leverage their assets to obtain growth capital. When companies were cutting costs, one area that shrank was inventory, resulting in a smaller pool of assets from which to use as collateral.
However, asset-based lenders that provided capital to companies unable to obtain traditional financing generally weathered the financial storm. Dean Chan, regional manager at Century Services Inc., noted that when the credit markets were tightening in 2008, 2009, their number of higher-quality borrowers increased. He also noted that senior lenders have been relatively patient with business clients that may have been struggling over the past couple years.
“But if that patience starts to wear thin, and it might in late 2011, then I think our opportunities will increase,” he said.
Tom Klausen is senior vice-president at First Vancouver Finance, which primarily provides a financing option called factoring, a form of lending based on a company’s accounts receivables. Businesses can use their receivables as collateral for a loan, or they can sell their receivables to a factoring company and obtain 80% to 85% of the amount in cash.
He was fairly optimistic about 2011, as companies grow and begin increasing their need for working capital, especially startups and small and medium-sized businesses, which may not be able to obtain bank financing. “In some cases, they are too small for the bank, or they are too big for their own personal collateral for a line of credit. We’re getting more inquires as people start realizing they need financing to grow their business.”
Factoring, and other alternative forms of financing, are more expensive. Many lenders noted that many face sticker-shock when they see rates that can be much higher than traditional financing. But costs are likely to decline as competition heats up in the financial sector over the next few years, barring another major financial crisis.
Said Napoli, “My prediction is that we will see compression in [rate] spreads. You’ll have multiple sources of financing. It’s not that you will be struggling to raise money over the next five years, especially for the better deals.”